Topic 1: Theories • Theory: a coherent group of propositions or principles forming a general framework of reference for a field of inquiry • Accounting theories explain and predict accounting practice (positive theories) or prescribe particular practice (normative theories) o Positive accounting theory (PAT) o System-oriented theories

Positive Accounting Theory • Tries to explain (or predict based on previous experience) existing accounting practices • Does not necessarily deal with what should occur according to accounting standards and the Conceptual Framework • Most large businesses in the USA have separation between management and providers of and debt financing • In other countries, there is separation between inside shareholders and outside equity and debt holders o E.g. many companies in Asia are controlled by family groups, but also have many outside shareholders • Assumptions: o All persons try to maximise their own self-interest o Rational behaviour, such that each individual is trying to maximise their own self-interest o Semi-efficient markets – markets are responsive to accounting choices and these choices can influence prices (e.g. stock prices) o Price protection – markets accurately adjust prices to reflect the actions of managers • Conflicts of interest arise between insiders and outside equity holders: o Difference in risk aversion o Shirking o Insiders tunnel firm’s funds to themselves via: ▪ Non-arms length transactions – fraud ▪ Insiders consume excessive perquisites o Horizon problem – insiders have short term focus and outsiders have long term focus o Over-retention of profits • Conflicts of interest arise between insiders and creditors because insiders try to maximise value of equity rather than value of firm (debt + equity). E.g.: o Excessive payments – leads to reduced to service debt o Claim dilution o substitution – taking high-risk projects do not benefit creditors because they do not benefit from upside gain (creditors receive a fixed payment), yet they may suffer from the downside risk (i.e. if the project fail, creditors may receive nothing) o Underinvestment • Excessive management perquisites and shirking can also be considered agency of debt if they lead to debt default • In perfect markets, these agency conflicts would be costlessly eradicated • Imperfect markets leads to residual agency problems, because we have: o Positive transaction costs

1 o Information asymmetry (insiders know more than outsiders about the firm, e.g. agents who manages the principals resources know more about the firm than the capital owners) • From these residual agency problems we get: o Demand for accounting and auditing o Incentives to choose accounting policies systematically among firms

• Residual agency problems include agency costs of equity and agency costs of debt. These costs are shared between insiders and outsiders because the outsiders cannot estimate them accurately • Agency Costs of Equity results from a trade off between: o Decline in value of firm due to manager’s shirking and other conflicts with outsiders; and o Monitoring and bonding costs incurred to reduce the manager’s shirking, etc. behaviour • Agency Costs of Debt results from a trade off between: o Decline in value of debt due to manager’s attempts to shift wealth from debt-holders to equity-holders; and o Monitoring and bonding costs incurred to reduce that behaviour • Thus, agency costs = costs of monitoring and bonding + residual loss due to manager’s adverse actions against capital- holders that monitoring and bonding cannot stop because the to do so is too great

Agency Costs of Equity – Monitoring and Bonding Mechanism • Financial reporting • Management compensation (bonus plans) • Auditing (external and internal) • – e.g. committees, independent directors, etc. • Market for corporate control (takeovers) • Managerial labour market • Product markets

Agency Costs of Debt: Monitoring and Bonding Mechanism • Restrictive covenants on borrowing – e.g. borrowing firm may have to maintain debt/asset, coverage or debt/equity ratio, whereby violation leads to repayment in full • Monitoring (via general and specific financial reports) • Debt-holders have members on board of directors and remuneration committee • Dividend restriction

Quasi Contracting Costs and Political Costs • Refers to the possibility that the firm will have wealth transferred from it by governments or actions of special interest groups, e.g.: o Loss of special concessions o Increased taxes (mining super profits tax; carbon tax) o Government investigations (ASIC, ACCC) o Adverse publicity in the media

Role of Accounting in Monitoring and Bonding • Contracts often contain accounting hurdles

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Bridgeman Ltd signs a contract on 1 July (a) Recognition of costs incurred on the bridge construction project: 2014 to build a bridge for a customer at an DR Construction in progress 4,000,000 agreed contract price of $20 million. At the CR Cash/Trade Payables 4,000,000 date of signing the contract the estimated (b) Recognition of billing to customers: construction costs are: DR 3,000,000 CR Construction in progress 3,000,000

(c) Receipt of cash from customer Construction costs are the costs directly DR Cash 2,000,000 CR Accounts receivable 2,000,000 attributable to the construction, e.g. direct material, direct labour, manufacturing (d) Recognition of and expenses on the construction based on 25% * overhead. completion * ($4m actual costs incurred / $16m total expected costs) = 25% All other attributable costs in general, e.g. insurance, design, standard preparation DR Construction in progress 1,000,000 (gross profit increases (admin costs) and R&D are not part of the construction in progress) contract costs DR Construction Expense 4,000,000 (16m x 25%) CR Construction Revenue 5,000,000 (20m x 25%)

Bridgeman Ltd incurs actual costs to build Do we have to recognise a contract liability? st the bridge of $4 million by the end of 1 Look at the amount that we charged the customer by comparing AR with the year but still expects that the total costs of Construction in progress. If AR > Construction in progress  the company charged construction will amount to $16 million. the customer more than what they have completed. Here, the constructor must Bridgeman has invoiced the customer $3 recognise a contract liability: million during the first year but has only received cash from the customer DR Contract Asset amounting to $2 million by June 2015. CR Contract liability

Required: Provide journal entries for the AR = $3,000,000 – $2,000,000 = $1,000,000 financial year 2015, assuming the above Construction in progress = 4,000,000 – 3,000,000 + 1,000,000 = $2,000,000 cost estimates are reliable. AR < Construction in progress (contractor didn’t overcharge the customer)  there is no contract liability Bridgeman Ltd incurs actual cost of $8m for The percentage of completion of the contract at 30 June 2016 is calculated as the second year of the project (the year to follows: 30 June 2016). At the end of the 2nd year Actual costs so far $4m + $8m % Complete = = = 57% the management of Bridgeman expects Total expected costs $21m that the total construction costs for the bridge will amount to $21 million instead of Gross Profit recognised in: the initial assessment of $16m. • 1st year: Gross profit of (20m − 16m) × 25% = 1,000,000 • 2nd year: Expected loss $ (1,000,000) (expected cost Required: Provide journal entries for the 2nd of $21m LESS year contract price of (Hint: This means $1m loss is now expected $20m) from the construction of the bridge instead Less Profit already recognised 1,000,000 Loss recognised in 2nd year $ (2,000,000) of the initial assessment of $4m profit)

Construction expenses recognised in the 2nd year: (21m × 57%) − (16m × 25%) = 8m

3 (57% is an accumulative figure, so you need to deduct the expense in the first year)

Construction Revenue = $6m (Loss = $2m, Construction Expenses = 8m, revenue = $6m)

OR, calculate the entry in the CIP first, the ‘construction expenses’ becomes the balancing item:

The Bridgeman Ltd journal entry to record the contract revenue and contract expenses for the year to 30 June 2016 is as follows: DR Construction Expenses 8,000,000 CR Construction Revenue 6,000,000 CR Construction in progress 2,000,000

Alternatively, you can make the following journal entries to record the construction revenue and expenses for the year ended 30 June 2016 (same as textbook) 1. DR Construction expenses 1,000,000 CR for Loss on construction contract 1,000,000 (A liability on an ‘onerous contract’ is recognised because the cost of settling the performance obligation ($21m) is expected to exceed the amount of the transaction price allocated to that performance obligation ($20m))

2. DR Construction expenses 1,000,000 CR Construction in progress (contract asset) 1,000,000 (Reverse the profit recognised in 2015)

3. DR Construction Expenses 6,000,000 CR Construction Revenue 6,000,000 (Recognition of for 2015 and recognition of expenses for the same amount, $6m is obtained as shown above)

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